As Hagstrom said to me earlier this week, “An accountant knows the difference between a debit and a credit, an attorney knows the difference between a felony and a misdemeanor, a doctor knows the difference between a virus and bacteria. So how is it that the financial industry can’t define the difference between investing and speculation?”

If you think you are investing when, in fact, you are speculating, you’re likely to be surprised by worse losses than you can imagine. If your financial adviser speculates with your account when you want only to invest, you will get saddled with risks you aren’t likely to withstand.

But what exactly separates investors from speculators?

I thought I knew, but now I’m not so sure.

When Hagstrom first contacted me a few weeks ago to chat about the idea, I immediately retorted with words I learned by heart more than 20 years ago, first written by the great financial analyst Benjamin Graham in 1934: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”¹

Is it that simple?

In his 1934 masterpiece, Security Analysis, Graham elaborated on the definition.

He used the term “investment operation” rather than “investment” because sometimes “the element of safety is provided by the combination of purchase and sale.” Graham often engaged in merger arbitrage, buying one stock or bond involved in a corporate takeover while selling or “shorting” securities of the company on the other side of the deal. Or, during a corporate reorganization in a bankruptcy, he might buy one type of a company’s securities while shorting others issued by the same company. In these and other types of hedging, the safety and return are the result of an “operation,” simultaneously buying and selling more than one security at a time.

Graham added: “By thorough analysis we mean, of course, the study of the facts in the light of established standards of safety and value.”

Continued Graham: “The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations…. a safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.”

Finally, Graham explained, “A satisfactory return…is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.”

Much to my surprise, once I thought through Graham’s classic definition point by point, I found that it wasn’t quite as watertight as I had always believed.

If merger arbitrage is an investment operation, then what about today’s widespread practice of “statistical arbitrage”? A stat-arb trading firm might, for example, buy all the underlying stocks in an exchange-traded fund and simultaneously short-sell the ETF if it believes that the ETF is slightly overvalued. These firms use no leverage or borrowed money; they “go home flat,” closing out all their positions at the end of the day to minimize risk.

Some of these same firms are otherwise known as high-frequency traders; they hold their positions for only hours, often even only a few minutes, at a time. Typically they use no human judgment whatsoever, guiding their “operations” purely with lightning-fast computer programs that tap directly into trading data provided by the stock exchanges.

Is that investing? The very suggestion that high-frequency traders might, in fact, be “investors” seems absurd and repugnant. But how, other than their short time horizons, do the operations of such traders differ from the arbitrage that Graham himself believed to be a form of investing?

And if there is a minimum holding period required for someone to be considered an “investor,” how long is it?

It’s hard to believe that anyone who keeps a stock for only a few minutes at a time can be investing, but where is the dividing line? Is the minimum holding period one month? One year? If so, bear in mind that the average holding period among U.S. mutual-fund managers is 11 months, according to Morningstar – meaning that the typical fund manager isn’t “investing.” Is it three years? (Why?) Is it five? (Why?)

Furthermore, Graham’s argument that “where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation” isn’t entirely satisfying.

No matter how thorough your analysis of an asset, there is always an appreciable chance of loss – as Graham knew better than anyone. As careful an analyst as he was, he lost roughly 70% in and after the Great Crash of 1929. In the 1972 edition of his book The Intelligent Investor, he warned that a stock investor must reconcile himself to the “probability” rather than the “possibility” that “most of his holdings” will fall by at least 33% several times over five-year periods.

So, it seems, “an appreciable chance of loss” is a part of investing as well as of speculating – by Graham’s own admission.

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*In later versions of his writings, Graham often reworded this slightly: “An investment operation is one which, upon thorough analysis, provides safety of principal and an adequate return.” (Italics mine.)